A disregarded entity is a one-person business structure not taxed separately from its owner for federal income tax purposes. The single-member limited liability company (SMLLC) is the most common disregarded entity.
That means the business is not required to file its own tax return. Instead, the owner reports their business profits on their return. This is because the Internal Revenue Service “disregards” the fact that the owner and business are separate.
While the business entity and owner are legally separate (and the owner has some liability protection), the business’s profits pass through to the owner’s tax filing. So if your earnings are $50,000, you as the business owner are taxed on $50,000 through your personal tax return.
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Which business entities are considered disregarded entities?
Only one type of business. When you form a single-member LLC, you default to being a disregarded entity. Some entrepreneurs use this structure to protect the owner’s personal assets.
Don’t let the word “default” scare you. A disregarded entity is simply a tax classification, not an official business entity structure, and you can request to change your classification without changing your legal structure. (More on that later.)
You may see this term appear when you’re completing documentation for the Internal Revenue Service (IRS), such as when you fill out an application for an Employer Identification Number (EIN).
You’ve probably noticed that we’ve been using fancy language to talk about a pretty simple concept: Single-member LLCs are considered disregarded entities unless they request to be taxed differently.
But what about sole proprietors?
While sole proprietors pass business profits through to the owner’s personal tax return, sole proprietorships aren’t classified as disregarded entities because they don’t register as separate entities with their state.
And multiple-member LLCs?
Multi-member LLCs are taxed as general partnerships by the IRS and are considered separate entities from their owners. So, MMLLCs must file separate returns from owners’ personal tax returns. They must also prepare a Schedule K-1 for each member.
So, while the IRS doesn’t accept any form of LLC as a taxable entity, it treats single-member and multi-member tax classifications differently.
Why is the IRS biased when it comes to LLCs? Because an LLC is not a tax structure, it’s a legal structure. While taxes and legal protection seem to go hand in hand, they are two separate things. The legal protection you receive from an LLC is based on your state’s rules about LLCs, while your tax treatment is based on the IRS’s tax classifications.
Since an LLC is not a tax classification, the IRS has to give you a default tax classification.
How are disregarded entities taxed?
Disregarded entities are taxed the same way as sole proprietors.
If you’re a single-member LLC who hasn’t changed your tax classification since forming your company, you’re paying taxes like a sole proprietor.
Sole proprietors are pass-through entities and are taxed on their taxable business profits. Taxable profits are left after subtracting your tax deductions from your total income.
There are two taxes disregarded entities pay:
- Self-employment tax, which is 15.3 percent
- Personal income tax, which varies based on your tax bracket
Sales tax, employment taxes, excise taxes, and franchise tax still apply. Payroll taxes may also apply to disregarded entities if they have employees. Some single-owner LLCs opt to be taxed as an S corporation (S corp) to reduce payroll tax liability.
As a disregarded entity, you report your total business income, expenses, and profits on Schedule C, which you file with your Form 1040: US Individual Income Tax Return. The information from Schedule C is added to line 3 of Schedule 1: Additional Income and Adjustments to Income. This information is then reported on your 1040 tax return.
Even if you don’t use the business profits personally, you’re still taxed on the total profits because they are automatically “passed through” to you, the owner.
What are the pros of being a disregarded entity?
1. Filing taxes is easier
Since you and your business are taxed together, you only file one federal tax return, saving you time and money. (This guide provides an overview on how to file your small business taxes for the first time.)
2. You have legal protection
Another benefit is that you have some legal protection between your personal assets and your business assets. If someone sues your business or you have unpaid debts, in many cases, creditors and claimants can only go after your business assets.
3. You’re not subject to double taxation
Finally, unlike a corporation, disregarded entities aren’t subject to double taxation.
When you’re a corporation, you pay taxes twice. First, the business pays taxes on its profits at the corporate tax rate of 21 percent. Then, the owners pay taxes on the dividends they receive.
What are the cons of being a disregarded entity?
1. The self-employment tax
Many consider the self-employment tax to be the biggest con of being a disregarded entity. Since you pay self-employment tax on top of income tax, it can seriously increase your overall tax liability.
2. It can be harder to raise money
Another con is that raising money from investors as a disregarded entity can be more challenging. Some investors prefer C corporations because they can issue different types of stocks. It’s also easier for them to receive dividend payouts.
How do I become a disregarded entity?
If you’re the owner of a single-member LLC, your business is automatically a disregarded entity, and you can file your taxes as usual.
You can’t become a disregarded entity if you’re not a single-member LLC. It’s as simple as that.
How do I change my tax classification from a disregarded entity to another entity?
If being a disregarded entity isn’t your jam, you can request to change your tax classification. If you want your LLC to be taxed as a corporation or partnership, you’ll use Form 8832: Entity Classification Election. To be taxed as an S corp, you’ll use Form 2553: Election by a Small Business Corporation.
You’ll only complete one of these forms to change your tax classification, not both. The form you use depends on how you want to be taxed. Each of these guides provide a line-by-line walkthrough of Form 8832 and Form 2553.
Can I change my tax classification back to a disregarded entity?
Yes, but the IRS doesn’t want you changing your tax classification all willy-nilly, so there are a few caveats.
If you’re switching your tax classification from a corporation back to being taxed as a sole proprietor, in most cases, you can only change your tax classification once every five years.
The exceptions are:
- You selected your tax election status when you formed your entity.
- More than 50 percent of your business’s owners have changed since the effective or filing date of electing the previous tax classification (and the IRS permits the change in classification in a written statement, aka private letter ruling).
If you’re eligible to change your status, you’ll use Form 8832.
The same rules apply if you’re switching from an S corp back to being taxed as a sole proprietor. You can only change your classification once every five years, unless you made your tax election when you formed your entity. If you qualify to change, you’ll use Form 2553.
When to use Form 8832 and Form 2553
It can be confusing, so we made this handy chart for you:
| Current Tax Status | Switching To | Form |
| Disregarded entity (taxed as a sole proprietor) | Corporation | Form 8832 |
| Disregarded entity (taxed as a sole proprietor) | S Corp | Form 2553 |
| Corporation | Disregarded entity (taxed as a sole proprietor) | Form 8832 |
| S Corp | Disregarded entity (taxed as a sole proprietor) | Form 8832 |
FAQs
Is a DBA the same as a disregarded entity?
DBA means “Doing Business As,” which indicates a public-facing name of a business entity. It does not affect the way a business is taxed. Suppose your company uses another name other than an official one. In that case, you should register the DBA and add that information to your bank account to ensure checks and other monetary instruments written to your DBA can be deposited.
Is an LLC owned by a trust a disregarded entity?
Yes, an LLC owned by a trust can be a disregarded entity for tax purposes if the trust’s sole owner (aka grantor) retains the trust property (funds, real estate, etc.) for themselves. But remember that the IRS considers the grantor as the true owner of trust property, even though the trust legally owns the property.
Does a single-member LLC need an EIN?
Because taxes can fall under the Social Security number of the owner of a SMLLC, you’re not legally required to get an EIN for one. But you may need an EIN for some tax and banking purposes, even if your SMLLC has no employees.